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Dollar resurgence: A double-edged sword for investors

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15 Jun 2022

Economic and geopolitical newsflow is forcing the dollar and the pound in different directions. Mona Dohle looks at what this means for investors.

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Economic and geopolitical newsflow is forcing the dollar and the pound in different directions. Mona Dohle looks at what this means for investors.

dollar strong currency us

There are few safe havens in today’s market environment. Investors seem to consider the greenback as one of them.

The dollar has increased by more than 13% so far this year, hitting a 20-year high against other major currencies. This is not the first time the US currency has surged ahead of its peers.

Between 1980 and 1984, the dollar appreciated by 26%. Just like in the 1980s, monetary tightening is a driving factor in the appeal of the greenback. But investors who wish to draw parallels might do well to heed Mark Twain’s claim that “history doesn’t repeat itself but it often rhymes”.

While there are some parallels to the aftermath of the Volcker shock in the early 80s, there are also unexpected differences.

Besides a bet on the effects of monetary tightening in the US, the rising dollar could also be due to the relative weakness of other developed currencies. The value of the euro, for example, continues to fall amid growing fears of a recession and the European Central Bank (ECB) is keen to delay monetary tightening. Similarly, the Bank of Japan’s priority seems to remain lower borrowing costs.

Meanwhile, the yuan is also on a downwards trajectory due to China’s worsening economic outlook. More importantly for UK institutional investors, the pound is also falling against the dollar. Year-to-date, sterling has fallen to 1.2477 from 1.3671, according to Refinitiv, a significant change for pension schemes whose liabilities are measured in pounds.

Currency perks

Defined benefit (DB) schemes might be shrugging their shoulders at the news. Larger, more mature schemes, in particular, should have most of their currency exposure hedged. Within their equity portfolios, 68% of DB schemes have hedged at least 40% of their currency risk and 44% of schemes have hedged more than half of their equity portfolio, according to Mercer’s asset allocation survey.

But for less mature funds, the rising dollar has been an opportunity and they have purposefully not fully hedged their currency exposure. Examples include Local Pensions Partnership Investments (LPPI), which has not hedged the currency exposure in its US dollar-denominated global equity funds as a way to seek dollar exposure. LPPI chief investment officer Richard Tomlinson predicts that the dollar will continue to appeal as a safe haven in economically uncertain times.

Similarly, many defined contribution master trusts have not fully hedged their currency exposures. The People’s Pension, for example, has hedged 70% of such holdings which include US dollars, euros and the yen.

For the 30% of its dollar holdings that are unhedged, it is now benefiting from a rising greenback. Nest has also hedged only half of its US equity exposure and is therefore benefiting from a rising dollar. UK schemes are not the only ones banking on a rising dollar. Since the global financial crisis, US stocks held by foreign investors have surged to just above $12trn (£9.6trn) from $20bn (£16bn), according to Bloomberg.

Macro troubles ahead

While this is good news for some investors in the short run, it could also be an indication of serious macro-economic troubles brewing, as Allianz adviser Mohamed El-Erian warned in a Financial Times column. For starters, a rising dollar tends to be bad news for emerging markets, particularly those who are heavily reliant on imports of food and energy and those who have a heavy external debt burden.

In both cases, the rising dollar will add to inflationary pressures and push some of the poorest people on the planet over the limit, El-Erian said. It is no wonder then, that the MSCI Emerging Markets has dropped by more than 12% since the start of the year.

Reserve currency

Over the longer term, there may well be powerful factors that will reverse the rise of the dollar. The key question will be if it can maintain its status as global reserve currency. At the moment, close to 40% of global transactions are conducted in dollars. Its dominant status means the US benefits from lower borrowing costs, a stable exchange rate and the ability to run a large deficit.

But this privilege is increasingly being questioned, among others by former Bank of England governor Mark Carney, who argued in 2019 that the dollar dominance represented a barrier to economic recovery. He predicted that it could eventually be replaced by a global digital currency.

Another theory, fuelled by the war in Ukraine, is that the yuan could rise in prominence. The Chinese currency only accounts for 2% of global transactions. While Russia is unwinding its US dollar reserves and converting them into yuan, Saudi Arabia is also taking steps to accept the yuan, rather than dollars for the sale of its oil.

These factors could undermine the dollar’s status and in turn hamper with the Fed’s ability to introduce monetary tightening. In that case, investors in US assets will do well to review their currency hedges.

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